Fund family feud

The lessons of indexed vs. active styles

BOSTON (MarketWatch) -- As a general rule, the Hatfields aren't looking to the McCoys to learn any lessons about successful feuding. But in mutual funds, there is little doubt that in the ever-raging debate between active and passive investors the folks who believe in picking and choosing their issues can learn something from the people who build funds to emulate an index.

The basic debate boils down to management acumen. Active investors believe a manager can add value, either by performing better on the upside or protecting them against declines, while the indexer believes that the best way to capture the profits of the market is to buy the market rather than trying to beat it.

While the supporters of each strategy sometimes seem diametrically opposed to the other, the truth is that they can learn from each other, particularly at this time of year when many indexes are going through their annual or semiannual "reconstitution" process.

Last week, the Russell Investment Group announced the preliminary annual changes being made on its broad-market Russell 3000. In all, 277 new names will go onto the index, replacing companies that failed to keep up with the market's growth, were merged out of existence or taken private. Over the last 10 years, the average year has seen 405 names changed during the annual reconstitution.

When about 13% of the portfolio changes each year, one could question whether the passive indexing strategy actually takes an active bent. And it's not just Russell's benchmarks that are going through the process; Morningstar Inc. is in the process of its semiannual recalibration of the Morningstar U.S. Index. And even new benchmarks like the Clear Spin-Off Index -- a benchmark from Clear Indexes that looks at recently spun-off businesses -- is going through its semiannual rejiggering.

The process is a form of active management, but done in an unemotional, detached sort of way. That's where the lesson comes to light.

If the people behind the indexes did not make changes, their benchmarks would quickly stray from their real purpose, replicating a specific segment of the market. To remain passively invested actually requires some level of active management.

Obviously, the Russell changes sometimes highlight which industries are hot, the companies where the market value has grown to catapult them toward the upper echelons of the market. This year alone, the market capitalization of the smallest company on the Russell 3000 jumped by $40 million; roughly one-third of the 2007 additions are in the financial-services and health-care industries, reflecting growth in those businesses.

That might seem like chasing what's hot, but it is actually making sure the index reflects the companies that really are the largest and letting the real world decide which stocks qualify for the list.

Rebalancing act

For individual investors, failing to periodically rebalance a portfolio -- culling your winners and putting asset allocations back to their target levels -- allows investments to get off track.

"There's no question that ordinary investors can learn from this," says Steve Wood, senior portfolio strategist at Russell. "If they picked an asset allocation, returning to those targets once a year -- and doing it unemotionally -- makes sure that their portfolio reflects the strategy they intended."

For Russell, the repositioning is a bit like regular maintenance, the next service check-up on the warranty plan. The indexes have rules, and the managers are just sticking to those guidelines.

That's where the lesson comes in.

Even active investors should have their rules for running money. Most investment advisers, for example, suggest rebalancing either once a year, or whenever the portfolio is 5 to 10 percentage points off course.

To see why it works, consider a simple example: Jack invests $10,000 splitting it equally between a broad market index fund and a general-purpose bond fund. If, over the course of a year, the stock side is up 20% while the bonds are up 5%, the portfolio will tilt. After that year, the money is not invested in two equal halves, but rather has 53% in stocks and 47% in bonds.

The longer a trend of unbalanced returns continues, the further off target the investor gets and the more vulnerable the portfolio is to market reversals.

But getting too tied up in seeking perfection and reconfiguring a portfolio too frequently creates its own set of problems. Russell, Morningstar and the rest could change their benchmarks daily to stay perfectly on point, but the constant moves would defeat the purpose.

Says Wood: "You want to capture the expected performance and stop the drifting. You don't want to worry about making things perfect. Too many changes are as bad as doing nothing at all. ... It's not timing the market, it's just picking the time every year when you will make your changes, and having rules to follow so that you can make those changes easily and without emotion."

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